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Banking Sector Report - May 2018


US banks were little changed in May as it did in April. In May BKX index increased by 1.0% MoM vs +2.2% of SPX index. In fact, in the first part of month banks demonstrated positive performance due to strong quarterly results, expectations of both rising SIFI buffer and further growth of the Fed Funds rate. But in the end of month BKX index decline significantly because of growing political uncertainty in Italy. So, banks underperform SPX index at the moment. Absolute May performance on MoM basis was -0.3 StD from the mean performance. It is in the bottom 36% absolute monthly performance of BKX Index. Relative May performance vs SPX index was -3.1% MoM in absolute terms, it is -0.7 StD from the mean. The result is in the bottom 18% of relative performance of BKX index vs SPX.

Dynamics of US banks was quite uniform in the first part of the month but then most asset sensitive banks declined significantly and went into the red zone eventually. FITB declined earlier because of acquisition of MBFI. In turn, regional banks with good quarterly results and high benefits from rising SIFI buffer ended the month in the green zone.

May FOMC meeting was largely in line with expectations leaving the fed funds rate target rate unchanged at 1.5%-1.75%. The key changes were in wording. FOMC meeting results were perceived neutral by the market but the minutes of the meeting, which were released on May 23, were perceived as dovish one because of remark on the wishful inflation – “a temporary period of inflation modestly above 2 percent would be consistent with the Committee's symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective”. After the minutes, yields moved down significantly. From our point of view, this reaction was caused by the fact that wording about inflation was markedly relaxed in May FOMC statement and remark on the inflation overshoot in the minutes was somewhat unexpected. It was removed the “monitoring closely” remark and was added “the Committee's symmetric 2 percent objective over the medium term” comment. It was also noted that the yield curve continue to flatten but it is not perceived by the Committee as a problem (banks would prefer to see the opposite statement). As well, it was noted “several participants thought that it would be important to continue to monitor the slope of the yield curve, emphasizing the historical regularity that an inverted yield curve has indicated an increased risk of recession”. As for the rest, there weren’t any big surprises – “the labor market has continued to strengthen and that economic activity has been rising at a moderate rate”, “risks to the economic outlook appear roughly balanced”, “the stance of monetary policy remains accommodative”.

April 2017 Senior Loan Officer Opinion Survey confirmed earlier emerging trends. C&I lending standards were eased to large and middle-market firms over the past three months (the fifth consecutive quarter of easing), while standards for small firms were basically unchanged, the second quarter in a row after 3 consecutive quarters of easing. Banks noted that demand was weaker but, according to the Fed H8, C&I loan growth accelerated in the first five months of 2018. Nothing has changed for CRE loans – banks continue to tighten standards. Banks also reported that demand for CRE loans was weaker during the last quarter. Lending standards for majority mortgage segments were basically unchanged in 1Q18, but standards for revolving home equity lines of credit (HELOCs) were eased. Banks continue to tighten standards for auto and credit card loans. Demand decreased in all major consumer categories. More aggressive competition from other banks or nonbank lenders remains the key reason of easing standards.

Economic surprise indexes slightly decreased in May. Currently, they are markedly lower than they were at the beginning of the year but they still remain on the positive territory. Overall, macro data is still at a decent level and it continues to indicate healthy growth of US economy. However, consensus estimates of US GDP growth in 2019 and 2020 years were decreased by 10 bps and 20 bps, respectively, in May vs April estimates.

In May EU banks shares collapsed because of growth of Italian political uncertainty. SX7P index decreased by 9.0% MoM vs just -0.6% of STOXX 600 Index. In result, banks declined to levels of December 2016. Absolute May performance of SX7P was -1.4 std from the mean and this result is in the bottom 8% of absolute monthly performance of SX7P since the index inception. As broad market index was little changed, SX7P index underperformance was huge, -8.5% or -2.34 Std. This result is in the bottom 2.5% of relative monthly performance.

Dynamics within the sector was uniform. Only RBS managed to end the month in the green zone. The key reason is decreased risks because of $4.9 Bn US RMBS settlement. Of course, the key underperformers were Italian banks majority of which declined approximately by 20% MoM. Significant decline was also demonstrated by Deutsche bank which was added to list of troubled lenders monitored by the FDIC.

The Italian political situation was the main news of the past month, especially in the last week of May. In result, Italian sovereign spreads skyrocketed by 135 bps in May to 2.57% from 1.23% at the end of April. During 29 May, the yield of 10yr Italian Government bond increased to 3.44% at some moment after 2.68% at the end of May 28. In turn, prices of European banks collapsed as there is a strong inverse correlation between sovereign spreads and banks performance. The trigger of sales was a failure to form a government in Italy and, as a consequence, a possible need for new elections as well as no-confidence vote in Spain which could also lead to growing political uncertainty in the country and possible new elections in the future. But eventually, the agreement was reached on the first day of June and Giuseppe Conte, the new prime minister, was approved by the President Sergio Mattarella. The new government will need the confidence vote of the Parliament in the nearest time but markets have already rallied after the president’s approval as political uncertainty reduced. However, high political uncertainty could remain for a long time, from our point of view, as it is not clear how long this coalition will last so the risk of early elections has only slightly decreased, not disappeared at all. But we don’t think that any of the serious risks will be eventually realized but prolonged uncertainty could negatively impact on the growth of the economy.

Recent sell-off has raised many questions about Italian banks and their financial stability. The question is reasonable taking into account that substantial part of the Italian public debt is held by Italian banks. So, they must mark-to-market these securities every quarter and it could negatively impact on their capital ratios. As well as rising rates and spreads inversely correlated with valuations. Rising risks could also be a reason for ECB to delay the end of APP announcement and, accordingly, the growth of rates will be delayed either. In case of slow down of the economy because of elevated political uncertainty, it could negatively impact on loan and revenue growth. But the key problem is that the process of NPL/NPE disposals may slow down while it is one of the main drivers for Italian banking stocks. Of course, all these are risks for business of Italian banks. But the probability that these problems will eventually be a problem for financial stability of Italian banks is low, at least currently. So, at the moment we consider the sell-off as an opportunity to buy our top-picks, for example, UniCredit (UCG IM) which decreased by 21.4% in May, as dynamics of operating results of Italian banks remains encouraging. Yes, it highly likely that we will not see significant outperformance of Italian banks until the political saga finally ends. But for long-term investors current levels are very attractive, from our point of view, although, of course, it should be noted that the risks have increased recently.

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